April 2022
Key takeaways
► Tough quarter for stocks and bonds
► Inflation worst in four decades
► Fed getting tough on inflation
► War in Europe makes everything worse
► Stick with high-quality companies
Bad start to the year
This is the first time I am writing a quarterly letter for my firm, HG Wealth Management LLC, where all of the numbers in the table above are negative. It is very unusual for stocks and bonds to be down at the same time. The two main culprits are war and inflation.
The quarter-end drop of 4.60% in the S & P 500 index of large US stocks masks a lot of volatility. The high for the S & P occurred on the second trading day of the year, Tuesday, January 4, when it finished at 4793.54. Investors were coming off a fantastic 2021, and many were optimistic that the Omicron variant would not cause mass lockdowns and economic disruptions. It was downhill from there. Inflation readings kept coming in higher and higher. The low came on March 8, two weeks into Russia’s invasion of Ukraine, when the index hit 4170.70, down 13.05% year-to-date, often called a correction in market jargon. The Nasdaq was down more than 20% into what Wall Street calls bear market territory. Both have since rallied. The S & P 500 crawled up an impressive 8.62% from the bottom to finish the quarter down only 4.60%.
Bonds were down too
Although the bond market is much bigger than the stock market, stocks usually take center stage in investors’ gaze while bonds toil quietly behind the curtain. Not this time. Rising inflation and news that the Federal Reserve will begin to raise rates have caused losses in the bond market to be the worst in decades. Remember that bond yields and prices move in opposite directions. The yield on the 10-year Treasury began the year at 1.52% and finished the quarter at 2.35% – a dramatic increase. The yield on the 10-year Treasury was only 0.50% less than two years ago. You have to look back to the 1980s for a similar environment of rapidly increasing yields.
Most of the time, bonds move in the opposite direction of stocks. Economic conditions that support stocks – strong growth, high employment, and robust consumer demand – are usually not good for bonds because these conditions tend to encourage inflation. Inflation is the enemy of bonds as it causes a bond’s fixed coupon payments to be worth less, particularly for longer-term bonds. Inflation eats into the purchasing power of a bond’s cash flow and causes the bond’s price to drop. On the other hand, stocks handle inflation better since corporate earnings may rise along with inflation as management passes higher costs on to consumers. But the sharp increase in inflation, uncertainty around the Fed’s plans, and the war in Europe were too much for stocks. Though investors often run to bonds as stocks fall, sometimes called “a flight to safety,” inflation has hurt bonds more than any gains from a flight to safety from the downdraft in stocks.
Inflation worst in four decades
Through 2021 and into 2022, inflation grew steadily month after month. As a result, the Federal Reserve eventually dropped using the word “transitory” when discussing its view on inflation. In addition, Russia’s invasion of Ukraine added more uncertainty to supply chains and the prices of essential commodities such as oil, metals, and wheat.
The Consumer Price Index (CPI) rose 7.9% from February 2021 to February 2022, following a January-to-January increase of 7.5%. Energy prices were the biggest gainer rising 25.6% February-to-February. Wheat jumped 31% in the first quarter alone.
Now all eyes are on the Federal Reserve and how aggressive they will be to dampen inflation. Tightening by the Fed is not good for bonds. However, the economy and inflation should eventually slow to the point where bonds are a good investment again. Whether that point may be this year or next, no one knows. Before then, we may even experience a combination of inflation and slow growth, called stagflation – the worst of both worlds. The war in Europe complicates matters further.
War in Europe
On top of shocking destruction, pain, and human suffering, Russia’s invasion of Ukraine has further strained already challenged supply chains and dramatically increased the price of energy, particularly oil and natural gas, and commodities like nickel, palladium, and wheat. Russia is the world’s largest supplier of wheat. Russia and Ukraine together account for a quarter of global wheat exports. Russia is the third-largest producer of oil. Europe gets 40% of its natural gas from Russia. Supply disruptions in energy and commodities will undoubtedly continue to force prices up further. The ripple effects are just barely beginning to be felt in the global economy and may stick around for a long time.
Where does this leave us?
It’s a tough time. No question. Patience is your friend. Avoid watching the day-to-day price action. Volatility will remain high and, though stomach-churning, can be to your advantage if you can buy or sell at extreme points. Keep cash on hand for better opportunities later in the year. I cautiously favor stocks as the better option as stocks can adjust to inflation better than bonds. I recommend high-quality, dividend-paying stocks – companies with strong balance sheets and ample cash flow. Real estate investments are also attractive as an alternative to bonds. Again, high-quality companies with robust cash flows are vital. But don’t run from bonds. As I have often stated before, keeping an appropriate amount in bonds is always essential despite low rates and inflation fears. Bonds are like ballast in a portfolio. They provide income and protection in a stock market collapse and threatening world.
Please let me know if you have any questions or concerns.
Sincerely,
Henry
Henry Gorecki, CFP®
HG Wealth Management LLC
401 N Michigan Ave, Suite 1200
Chicago, IL 60611
312-723-5116
